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IRS Leaves Hundreds of Millions of Dollars in Preparer Penalties on the Table(Title A)

Posted on Jan. 7, 2014

Alternate Title: IRS Measured Response to Preparer Penalties Suggests a Deliberate Approach to Combat Egregious Errors (Title B)

Congress and IRS alike have looked to somewhat unorthodox ways to control for high error rates associated with refundable credits.  The IRS’s in-limbo plan to more directly regulate commercial preparers is partly attributable to Congress’ increased use of refundable credits to achieve non-revenue raising objectives.  The sweet of using the tax system to deliver benefits is low direct administration costs; the sour is typically higher error rates relative to other transfer programs.  One of the items from Senator Baucus’ tax administration reform proposals of late last year was adding specific statutorily-required due diligence requirements for the child tax credit.  The earned income credit (EIC) is the one specific targeted due diligence requirement in the Code.

In this post, I will describe the status of IRS efforts to enforce one aspect of the EIC due diligence rules, the requirement that a paid preparer checklist be submitted along with the tax return. I highlight it because a recent TIGTA report shows that despite evidence of rampant preparer noncompliance with the submission requirement in the last two filing seasons, IRS assessed no penalties against noncompliant preparers.

One can frame the IRS’s failure to assess as the IRS dropping the ball on the issue. On the other hand, the IRS is affirmatively reaching out to many preparers who have not complied, and has stated that it will sanction those who are most noncompliant. Given the scarce resources the IRS has, and the uncertainty surrounding the related issue of regulating paid preparers, I think its approach of educating is prudent, though to be most effective it will have to keep its powder dry and sanction the most egregious preparers.

Some context and brief description follows.

Congress and IRS have been tinkering with the EIC due diligence rules to give them more teeth.  For example, per Section 6695(g), Congress has boosted the penalty for preparers who flunk the due diligence rules to $500 per failure, from $100 per failure. Through regulations under Section 6695, effective for the 2012 filing season, IRS now requires a preparer to submit Form 8867, the Paid Preparer’s EIC Checklist, with a filed tax return. Failure to submit a Form 8867 can trigger a $500 preparer penalty per failure.

Earlier this year,  TIGTA in a report discussing last year’s (2013) filing season faulted IRS for not assessing any penalties against preparers who failed to comply with the regulations’ checklist submission requirement even though thousands of preparers responsible for many EIC-claiming tax returns are not submitting any EIC checklists with the returns.

For example, TIGTA research showed that in the 2012-filing season (tax year 2011), “almost 534,000 (4 percent) tax returns with EITC claims totaling more than $1.5 billion were filed without the required Form 8867.”

The recent TIGTA report finds a similar state of noncompliance in last year’s filing season (tax year 2012), with as of late September the IRS still not having assessed penalties against noncompliant preparers.

Analysis of the more than 14.4 million tax returns with an EITC claim that were prepared by a paid tax return preparer as of May 2, 2013, identified 708,298 (5 percent) tax returns claiming more than $2 billion in the EITC where the IRS determined that the tax return preparer either did not include the required Form 8867, Paid Preparer’s Earned Income Credit Checklist, or included an incomplete Form 8867. These 708,298 tax returns were prepared by 122,133 tax return preparers who continue to not comply with EITC due diligence requirements.  (page 13)

According to TIGTA, IRS could assess approximately $354 million in preparer penalties for tax year 2012 stemming from preparer due diligence submission failures.

The IRS’s stated reason for not assessing penalties for tax year 2011 against noncompliant preparers was that the changes came in late in 2011, and that it wanted time to educate preparers who might not understand the new rules given that the submission requirement might not have been “fully disseminated.” (TIGTA Report, page 14)

For tax year 2012, IRS has taken a measured response to the failures. Starting last month, it sent letters to preparers it has identified as failing to comply with the submission requirements, and it previously sent warning letters to noncompliant preparers. IRS has posted sample letters here—though some of the letters address issues other than EIC, such as Schedule C.

Teasing out the information in the TIGTA report suggests that not all preparer violations are equal—some of the preparers are likely to be responsible for multiple failures. Likewise, TIGTA distinguishes between preparers who submit an improperly completed Form 8867 from those who submit no Form 8867.

The vast majority of those not complying are submitting incomplete checklists, rather than none at all. For example, last year, when it came to preparers who submitted no checklists, there were 52,000 paid preparers responsible for over 158,000 tax returns with $362 million EIC claimed, with a potential penalty amount of over $79 million.  Of those who submitted an incomplete checklist, there were about 69,000 paid preparers responsible for over 549,000 returns with $1.67 billion in EIC claimed, with a potential penalty amount of almost $275 million.

TIGTA’s report throws down the gauntlet and prods the IRS to start to sanction preparers who continue to violate the submission requirements.  TIGTA also suggested that IRS reach out to noncompliant preparers early in the filing season to allow preparers to become compliant and thus reduce the amount of potential penalty.  IRS in its response to the TIGTA report indicated that it was sending warning letters and would assess penalties against egregious or habitually noncompliant preparers. IRS believes that the TIGTA submission error rate is not accurate, and may not fully reflect software glitches that some preparers claimed was causing incomplete checklist submissions.

Some Parting Thoughts

I think that targeted due diligence requirements tailored to areas of systemic tax problems is generally a good idea.  Specific due diligence tailored to areas where research shows high error rates can increase accountability and visibility, two of the main drivers for tax compliance. Asking preparers to verify some essential facts and submit answers to specific questions about facts smokes out fibs and forces taxpayers to more directly misstate information to preparers.  It likely chills preparers who might turn a blind eye to circumstances that suggest a taxpayer is not entitled to a claimed benefit. More prominently highlighting facts relating to EIC eligibility will increase the psychological costs of cheating, and help preparers avoid unintentional mistakes.  Tax administrators have vastly underestimated the importance of psychological costs, a point I emphasized in an earlier post on Senator Baucus’ plan to include due diligence rules for child tax credits. That post highlights some of the insights of Duke Professor Dan Ariely, who draws heavily from behavioral psychology and other disciplines in an effort to nudge policymakers away from the notion of traditional rational actor compliance models.

The due diligence model comes with costs, including increased preparation time and likely higher fees for taxpayers visiting preparers. That cost also increases the attraction of black market or ghost preparers, something that Kelly Phillips Erb (Taxgirl) wrote about in an excellent piece last year on the Forbes blog.

My colleague Keith Fogg points out another cost associated with the due diligence rules. If the IRS penalizes all of the preparers TIGTA has identified, it places a significant burden on its system.  IRS may be looking at its available resources and waiting until it can budget for the employee time it will take to sort through that many penalties.  It might also be waiting to see what happens to the Loving case.  If it wins that case, it has different tools at its disposal to deal with preparers.

Notwithstanding what happens with Loving, absent an about-face, Congress will likely continue to use the tax code to achieve social policy. For those who are concerned with the integrity of our tax system, the due diligence rules are an innovative way to approach systemic problems.  A deliberate approach that uses the rules to root out the worst preparers initially in my mind makes good sense.  So, I would go with Title B to this post, though the success of the efforts to leverage preparers to reduce error rates will be dependent upon IRS efforts not only to educate, but to also punish those preparers who violate the rules.

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